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Hard to beat the market all the time
[NEW YORK] WHEN the stock market rose 30 per cent in 2013, plenty of fund managers had a triumphant year. Almost anyone can post good numbers in a bull market, though. It's like sprinting downhill with the wind at your back - the chances are good that you'll be pleased with your own performance. Outperforming most other people consistently, year in and year out, is obviously a much more difficult feat in any competition. But how rare is it, exactly, for stock market investing?
A new study by S&P Dow Jones Indices has some fresh and startling answers. The study Does Past Performance Matter? The Persistence Scorecard provides new arguments for investing in passively managed index funds - those that merely try to match market returns, not beat them.
Yet it won't end the debate over active versus passive investing, because it also shows that a small number of active investors do manage to turn in remarkably good streaks for fairly long periods.
The study examined mutual fund performance in recent years. It found that very few funds have been consistently outstanding performers, and it corroborated the adage that past performance doesn't guarantee future returns.
The S&P Dow Jones team looked at 2,862 mutual funds that had been operating for at least 12 months as at March 2010. Those funds were all broad, actively managed domestic stock funds. (The study excluded narrowly focused sector funds and leveraged funds that, essentially, used borrowed money to magnify their returns.) The team selected the 25 per cent of funds with the best performance over the 12 months till March 2010. Then the analysts asked how many of those funds - those in the top quarter for the original 12-month period - actually remained in the top quarter for the four succeeding 12-month periods till March 2014.
The answer was a vanishingly small number: Just 0.07 per cent of the initial 2,862 funds managed to achieve top-quartile performance for those five successive years. If you do the math, that works out to just two funds. Put another way, 99.93 per cent, or 2,860 of the 2,862 funds, failed the test. The study sliced and diced the mutual fund universe in a number of other ways, too, each time finding the same core truth: Very few funds achieved consistent and persistent outperformance. Furthermore, sustained outperformance declined rapidly over time. And the report said: "The data shows a likelihood for the best-performing funds to become the worst-performing funds and vice versa."
What should investors make of these findings? There is one clear implication, said Keith Loggie, senior director of global research and design at S&P Dow Jones Indices. "It is very difficult for active fund managers to consistently outperform their peers and remain in the top quartile of performance over long periods of time," he said. "There is no evidence that a fund that outperforms in one period, or even over several consecutive periods, has any greater likelihood than other funds of outperforming in the future."
This seems to bolster the case for index-fund investing. After all, if a fund manager with a great year can't be counted on to outperform other fund managers later, it's reasonable to ask: Why bother trying to beat the market at all?
A separate series of annual S&P Dow Jones studies has found that over extended periods, the average actively managed fund lags the average index fund. All of this may be enough to persuade you to abandon actively managed funds entirely.
But the story is more complex than that: The study also demonstrates that active managers can actually beat the market. Remember those two funds that did so consistently over the five years through March? The study didn't identify them but at my request, Mr Loggie did. They were the Hodges Small-Cap fund and the AMG SouthernSun Small-Cap fund, which were also the top two general domestic funds over the last five years till June, according to Morningstar performance rankings conducted recently for The New York Times.
Each fund has rewarded shareholders spectacularly, turning a US$10,000 investment to US$35,000 over those five years, the Morningstar data shows. By contrast, the same investment in a Standard & Poor's 500-stock index fund would have become more than US$23,000. While hardly shabby, that's not nearly as good.
I called the managers of the two funds. Both had good things to say about index funds, and about their own brand of investing. Craig Hodges, manager of the family-run Hodges Small-Cap fund, said that index funds are fine for many people, but that the intensive scrutiny that his team applies to the often-neglected small and mid-cap parts of the market should enable the fund to outperform the overall market in the future. "We won't do it all the time, of course," he said. "We'll have bad times. We'll make mistakes. But over the long run, I think we can keep doing very well."
Michael Cook, the lead manager of the SouthernSun Small-Cap fund and the founder of the firm that runs it, had a similarly nuanced view. Index funds deserve to be core holdings for many investors, he said, and despite his own fund's exceptional record, it may not be a good choice for everyone.
"One thing you don't want to do is just read about performance numbers - ours or anybody else's - and put money into an investment," he said. "Chasing past returns doesn't make sense." Asset allocation is crucial, Mr Cook said. Before putting money into a fund like his, he said, ask yourself: Do you really need more small-cap stocks in your portfolio? These smaller companies can be volatile, and they may well decline in price. Janet Yellen, the Federal Reserve chairwoman, warned last week of "stretched" valuations for small-cap stocks.
That said, Mr Cook spoke with the conviction of a true believer about patient, shoe-leather stock-picking discipline. He looks to buy shares in "businesses that we can own for a lifetime", he said. "We spend a lot of time understanding businesses we buy. And we keep checking them and their competitors and their industries. We need to really understand them." - NYT